Should San Berdoo cherry pick underwater mortgages?

July 13, 2012

By Wayne Lusvardi

What a ripoff. San Bernardino County wants to use eminent domain to let a private mortgage lender cherry pick “underwater” mortgages without paying damages to the lenders. Doing so supposedly would stimulate the resale market for homes.

The county’s policy would socialize the losses and privatize the gains of the underwater mortgages.  This would be done by acquiring underwater mortgages by eminent domain and re-selling them in the mortgage market for a discount.  Essentially, all taxpayers in the county pay would pay off the difference between the full acquisition price and the re-sell price through a municipal bond. The private mortgage company working for the county would make a fee from each sale.

Phil Angelides Previously Headed Mortgage Company

Mortgage Resolution Partners is the mortgage company selected by San Bernardino County to resell underwater home mortgages.  This company was recently headed by Democrat Phil Angelides, the former state treasurer lost a bid for governor in 2006. Angelides also was the chairman of the national Financial Crisis Inquiry Commission that mainly blamed banks, not government, for the 2007-09 economic crisis.

Angelides was also the co-developer of a residential subdivision called Laguna West in Elk Grove outside of Sacramento. Trulia.com reports there are 24 foreclosures and pre-foreclosures for re-sale in Laguna West today.

I’m no lawyer. But as an eminent domain appraiser for over 20 years, I would find the county’s proposal to condemn only “underwater mortgages” where the homeowner is still making payments as a likely violation of the legal rules for appraising just compensation in California.

The Entire Loan Portfolio Needs to be Valued

The mortgages to be acquired by eminent domain would have to be valued by appraisers for their “Fair Market Value.”  What would be appraised would not be the physical, tangible real estate of each home.  What would be appraised would be the intangible value of the underwater mortgages. An underwater mortgage is where the unpaid portion of the loan on the property exceeds the current open market value of the home.

The loans would have to be acquired for their remaining loan balance in order to make the lenders whole. Mortgage brokers or experts, not real estate appraisers, would subsequently be asked to value the mortgages for re-sale.  The mortgages would be valued not on the basis of the “comparable sales price” of actual homes, but the discount rate paid by mortgage brokers in the mortgage market.

According to securities expert and commercial real estate appraiser Steve Body of Eagle Rock, the discount is likely to be in the 50 to 60 percent range. This discount would have to be paid for by all county property taxpayers through a bond. Only the intangible loan value of the mortgages would be taken, not the physical real estate of each home with an underwater mortgage.

To comply with accepted “before and after” valuation methodology under eminent domain law in California, a condemning agency must retain an independent appraiser to value the “larger parcel” of the property to be taken.

For example, an agency may only want to acquire the farmer’s field. This is what is called a “part taking.”  But what has to be valued is the entire farm, including farm buildings, water wells, water rights, crops in place, chattels, any vertically integrated “ongoing” businesses, etc.

The same rule would likely apply in San Bernardino’s situation.  The “underwater” mortgages are part of a larger portfolio of loans.  Whole loan portfolios are valued in the private sector by discounting the cash flow from loan payments to their present value.  Loan portfolios likely have a mix of loans that are “not performing” (loan payments are in arrears) and loans that are “performing” (owner is current on payments).

As I understand it, what San Bernardino wants to do is cherry pick the best performing loans and leave the lenders with the loans that have been given Notices of Default and are in the process of foreclosure.  In short, they want to cherry pick the top of competitive lenders mortgage portfolios — all in the name of the “public interest.”

As many legal experts have stated, there is likely no doubt that the county has the right to define what is in the “public interest.”  The county can likely establish that it can take mortgages and allow a private lender to make a profit on them by reselling them.  This would be like taking someone’s home and allowing a private developer to upzone the land and make a profit on the higher use of the property for redevelopment.

But the county would have to re-write the Code of Civil Procedure and case law in California if it thinks it just wants to value those mortgages that are underwater and not the entire loan portfolio of the lenders.  This would be a gargantuan task because the county would have to appraise the entire loan portfolio of every lender, not just the 5,000 underwater mortgages it plans to take. We’re talking about countless thousands of loans valued as of a specific date. And the holders of the loans would have to be tracked down and identified, which may be an impossible task.

Severance Damages Also Need to Be Valued

Even if the entire loan portfolio could be valued, any “severance damages” to the remainder of the loans would also have to be appraised. The intent of just compensation is to “make the property owner whole,” not only for the property taken but also for any damages.

To use a farm example again, any damages to the remainder of farmland would have to also be appraised in addition to the value of the land taken.

As commenter Michael Baldridge appropriately wrote in the Wall Street Journal online:

“They want to seize the note. The note is worth what the note says. It’s the underlying collateral that is worth less. If they want to ‘seize’ the mortgage, they’ll have to pay the owner market value of the note, which is whatever is left on the mortgage. The underlying collateral is irrelevant. Using Mortgage Resolution Partner’s logic, the government could seize the note on a new car the second it drove off the lot, and the car is now worth 10% less. Then sell the car back to the owner for a 10% lower price (and lower payments), taking all the future payments while sticking the car dealer with the loss.” 

If the county cherry picked the best loans, then it would have to pay any damages to the remainder of the lender’s loan portfolio.

According to Body, if the county’s action results in leaving a greater proportion of non-performing mortgages in the lender’s loan portfolio, this would likely alter the portfolio to a status of “junk” (B-minus or lower credit rating).  The overall loan-to-value ratio, the percentage of under-performing loans, and the default rate would also have to be considered.

Uneconomic Remnant

If the remainder of a lender’s loan portfolio became unmarketable or worthless due to the county’s actions, the remainder of the portfolio could be deemed an “uneconomic remnant.” 

The term uneconomic remnant means: “a parcel of real property in which the owner is left with an interest after the partial acquisition of the owner’s property”; and which the government agency “has determined has little or no value or utility to the owner.”

In such an event — where the portfolio remainder has no value — the county could be legally compelled to acquire the whole portfolio.

Inverse Condemnation?

There are many other flaws in the notion to use eminent domain to acquire underwater mortgages to re-stimulate the housing market in San Bernardino.  Another of them is that such an effort is likely to impair the market value of properties for sale with no mortgages on them — where the homes are owned “free and clear” of any mortgage.  Bailing out the figurative water from “underwater” mortgages would flood the market with too much of a supply of homes, resulting in a decline in value.  Fire-sale prices would likely result as the pent up demand to sell previously over-mortgaged homes would flood the market and depress prices further.  The value of non-mortgaged homes would likely be dragged down along with the value of previously over-mortgaged homes.

This could give rise to what is called an “inverse condemnation” or “regulatory taking” lawsuit, where the property owner sues the government for a loss in value.

Fatal Flaw in County Proposal

Having to pay “severance damages” could be a fatal flaw that would likely make San Bernardino County’s proposal to acquire “underwater mortgages” economically infeasible and politically unacceptable.

If damages also had to be paid, the private loan reseller for the county would be unlikely to be able to make a profit.  Another option would be to have all property taxpayers in the county additionally pay for any damages to the remainder of the lender’s loan portfolio, as well as the underwater mortgages. Taxpayers might be outraged to have to pay damages as well as having to pay for what constitutes a gift to homeowners with underwater mortgages.

And if any homeowners file an additional lawsuit for “inverse condemnation” damages for impairing the market value and marketability of their homes, this could result in the county having to pay double damages to both the mortgage lender and third-party homeowners who couldn’t sell their homes.

San Bernardino County would be wise to ask the office of Attorney General Kamala Harris to issue a preliminary ruling of whether such a use of eminent domain is legal. And if so, the attorney general’s office should indicate whether the county would have to comply with the State Eminent Domain Code and the State Rule of Appraising Partial Acquisitions of property.

Advice also should be asked of eminent domain legal experts such as Gideon Kanner.

With San Bernardino city just declaring bankruptcy, and even faces a criminal probe, San Bernardino county shouldn’t compound the area’s economic problems.